Credit Market Competition and Capital Regulation

Banks can monitor their borrowers and by doing so influence managerial effort. Specif-
ically, each bank chooses a monitoring effort q and can constrain the manager’s actions so
that he exerts effort E = q, but this comes at a cost of cq² for the bank. The convex cost
function reflects the fact that it is increasingly difficult for a bank to control the actions
of a borrower. Our modelling of bank monitoring captures the idea that banks can help
to reduce an agency problem between the shareholders and managers of the firm, and thus
increase value.⁵ We note, however, that there are other equally plausible interpretations of
the influence banks have on firms that are consistent with our model. For example, banks
may instead have to choose how much effort to dedicate to screening borrowers. Firms would
benefit from such screening by enjoying more accurate pricing of the risk associated with
their loans and avoiding cross-subsidies to less-efficient borrowers.

Market structure: The loan rate rL and the amount of capital k are determined endoge-
nously, and can be set in one of two ways. They can either both be determined by the bank
or the amount of capital can be set by a regulator who maximizes social welfare. The market
is always competitive, but the solution will depend on the division of surplus between banks
and borrowers. We will distinguish between two cases for the allocation of surplus: first,
the case where there is a shortage of funds available to lend (N<M), and second the case
where there is a shortage of firms with good investment projects (N>M).

Timing: The model can be divided into 4 stages. First, the level of bank capital k is
determined, either by the bank or by a regulator. Second, banks set the loan rate r_L.⁶
Third, borrowers choose the loan that is most attractive to them. Finally, banks choose
their monitoring effort q once the terms of the loan have been set and they have raised
capital and deposits.

⁵ See, e.g., Besanko and Kanatas, 1993, Holmstrom and Tirole, 1997, Carletti, 2004, and Dell’Ariccia and
Marquez, 2005, for studies with a similar monitoring technology.

⁶ Note that, in the absence of regulation, this timing structure is equivalent to assuming that k and rL
are set simultaneously.

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